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Capital Gains vs. Ordinary Income

In a column titled “Capital Gains, Ordinary Income and Shades of Gray,” the Harvard economist N. Gregory Mankiw, who advises Mitt Romney in his presidential campaign, offers a fine teaching piece on the tenuous and often confusing line between ordinary income and capital gains under our tax code. As Professor Mankiw reminds us, the highest tax rate on ordinary income is now 35 percent while that on capital gains is only 15 percent.

Using four illustrations from transactions in real estate, Professor Mankiw concludes that the favorable 15 percent tax rate enjoyed by Mr. Romney on carried interest earned in his years at the private equity partnership Bain Capital is really not different in substance from the preferential tax treatment enjoyed by millions of other Americans on their real-estate transactions – quod erat demonstrandum (Q.E.D.).

I found myself persuaded by this argument, up to that point. But then, almost as an afterthought, Professor Mankiw touches in passing what for me is the crux of the issue. He writes:

Critics of current law think it is unfair that these private equity partners are taxed at capital-gains rates, whereas other high-income individuals like doctors and lawyers pay the much higher tax rates for ordinary income. It is a reasonable point, and some reform may well be appropriate. But as the tax situations of Abe through Earl illustrate, it is not obvious what the best approach would be. Not all problems have easy answers.

On this point, I beg to differ with my colleague. Why is the answer so difficult? To my mind, the best approach would be to abolish the distinction between capital gains and ordinary income altogether and desist from using the tax system for any kind of economic or social engineering.
The case for granting preferential tax treatment to the real-estate transactions that Professor Mankiw describes — and to carried interest in private equity firms — strikes me as extremely shaky on grounds of both horizontal equity and plain economics.

In his popular textbook “Principles of Microeconomics,” Professor Mankiw teaches students that “horizontal equity states that taxpayers with similar ability to pay should contribute the same amount.” Well put.

Consider now a person who bought a vacation home for $500,000 and two years later, during one of our recurrent real-estate bubbles, sells it for $1.5 million. That $1 million profit is now taxed at a rate of only 15 percent. If the home had been the principal residence of this person and his or her spouse, half of the $1 million profit would not be taxed at all.

Suppose next that this tax-favored person’s neighbor were a busy neurosurgeon whose many hours of hard, physical and intellectual work earned him or her a net practice income of $1 million during those same two years. That neurosurgeon would pay the ordinary income-tax rate on that income (on average a bit less than 35 percent, because only income over $388,350 a year is taxed at 35 percent).

By what definition of the term would can one call the glaringly differential tax treatment of the real estate investor and of the neurosurgeon horizontally equitable? Indeed, by what theory of justice could one defend it on ethical grounds?

Now, the argument may be that horizontal equity in this case must take a back seat to economic efficiency, as Congress seeks to encourage the formation of productive “capital” — including, apparently, owner-occupied residences and second homes.

But if encouraging capital formation is the argument in favor of the capital-gains tax preference, why not include in “capital formation” the formation of “human capital,” that is, the personal investment required to produce well-educated and well-trained individuals? Corporations and nations thrive economically on the strength of their human capital, which is arguably their most valuable asset.

A neurosurgeon, for example, who restores a stricken individual to good health and a productive life most assuredly represents a form of human capital capable of building yet other human capital. So, as I have argued, do conscientious parents, high school teachers and, yes, even college professors.

If the partners at Bain Capital are granted a low 15 percent tax rate on what basically is an earned commission for hours smartly worked, rather than a return on their own invested capital, should not the return on the neurosurgeon’s own investment in his or her human capital be granted the same preference?

If pressed, the proponents of the capital-gains preference might concede that a tax preference for gains on transactions in residential real estate is hard to defend; but they probably would not extend it to investments in financial securities, such as common stock of corporations.

Here the proponents of lower capital-gains taxation conjure up an image of, say, Jones purchasing shares of stock directly from the issuing corporation, which then invests the proceeds in new structures and equipment.

More typically, however, sales and purchases of corporate common stock take place among parties quite outside of the issuing corporation. For example, Jones may buy the stock from Chen, who may have reaped a capital gain from once buying and now selling the stock. Chen may have bought the stock from another person not related to the issuing company.

When Jones pays Chen, it is anybody’s guess what Chen does with the money. For all we know, Chen will spend it on a luxury car. Why, then, should any gain Chen enjoys on his or her investment in that stock be granted a tax preference? No new capital formation was supported by this trade in a stock sold by the company years ago.

Here the argument may be that when Chen achieved a capital gain on selling the stock to Jones, that capital gain must reflect an increase in the earnings per share of the underlying corporation, which was already taxed at the corporate rate. Taxing Chen’s capital gain at any positive rate, the argument goes, amounts to double taxation.

I find that argument an enormous stretch, especially in an era of high stock-price volatility and recurring bubbles in stock prices that are related much more to fluctuations in optimism and pessimism about the future — i.e., the risk premiums that traders price into their stock valuations — than to fluctuations in the underlying corporate earnings.

My bottom line on the issue of tax preferences is that although Congress may wish to encourage some transactions leading directly to the formation of new capital — including human capital — that preference is best expressed with explicit subsidies that show up in government budgets and for which politicians can be held accountable, rather than through tax expenditures that spare politicians explicit accountability for their indirect spending.

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